Will basic rate landlords be forced in to higher tax bands?

The new buy to let tax relief rules have an unexpected sting in the tail for many landlords who currently only pay the basic rate of income tax.;

Post Budget buy to let interest tax offsetting has become big news. You should be aware and planning for how the phased withdrawal of interest relief will impact your buy to let returns and your personal tax bill – there could be an unexpected sting in the tail for basic rate taxpayers.

Use this calculator to help you work out tax on buy to let income as you read the article. The calculator will open in a new browser tab so you can quickly cross reference.

Changes to offsetting buy to let finance costs

By now, we’ve all heard about the restriction to buy to let tax relief that the Chancellor announced in the July budget. To recap, the current system (wherein landlords can offset buy to let finance costs, such as mortgage interest) will be replaced with a tax reduction equal to 20% of finance costs incurred that year.

Basic-rate taxpayers should be unaffected – but there is a bigger picture

The government’s own budget document refers to the change as “[restricting] relief for mortgage interest … to the basic rate of income tax”, and refers to the tax benefit enjoyed by “wealthier landlords” who pay “40p or 45p less tax” for every £1 of mortgage interest they incur [1]. The impact assessment released on the same day claims that the changes will affect landlords “with above average incomes” [2].

You could be forgiven, then, for thinking that only landlords on the higher and additional rates would see their tax bills rise. However, one crucial distinction means that landlords who currently only pay tax at 20% might also be affected.

How basic rate landlords could end up paying 40% tax

Income tax bands are determined by taxable income. Rental income is considered taxable, but any income against which you offset running costs is not taxable. So if you earn £20,000 from your properties and incur £15,000 in expenses, only £5,000 of your income will be taxable. This £5,000 represents your ‘real’ profit, as it is net of all outgoings throughout the year.

Your personal allowance of £10,600 also reduces your taxable income – so if your rental income was the only money you earned for the year, under the current system you would in fact pay no tax.

Under the new system, you will not be able to offset finance costs, meaning any income formerly covered by these costs will become taxable. This could, in some cases, have the effect of pushing a basic rate taxpayer into the 40% bracket.

Revisiting the above example: let’s say that of your £15,000 expenses, £10,000 was buy to let mortgage interest. Under the new system, your taxable rental income would jump from £0 to £4,400 (£15,000 less your personal allowance).

Now let’s say that your £20,000 rental income was in addition to a £30,000 salary. At present, your taxable income would be £24,400: £50,000 less buy to let mortgage interest, other expenses and your personal allowance. This would amount to a £4,880 tax bill for the year.

If the new regime were in place, your taxable income would be £34,400 (£50,000 less £5,000 deductible expenses and your personal allowance) – enough to take you into the 40% bracket. You’d therefore pay tax as follows:

20% on £31,785 (£6,357)

40% on £2,615 (£1,046)

Less your 20% mortgage interest reduction, your total tax bill would be £5,403. This represents a tax increase of £523 per year, or around £44 per month. In terms of relative tax on your total income (main income plus real rental profits), the amount of tax you pay has risen from 13.9% to 15.4%.

Landlord tax bills could go up without supporting profits

Landlords in this position are hit particularly hard by the new system because their tax will increase even though their profits don’t justify it. By taxing income before finance costs, even with the basic rate reduction, some landlords on average and below average incomes will still see their tax go up.

Some could even pay more in tax than they earn

Some landlords have much larger portfolios from which, due to high leverage, they derive an average or below average income. Under the current system, some landlords in this situation still pay only 20% tax.

Let’s say you own a property portfolio that generates £200,000 per year in rent and incurs £175,000 in expenses, £125,000 of which is mortgage interest. Your profits for the year are £25,000, and under the current system, you would pay £2,880 per year in tax.

Under the new system, however, your tax would be broken down as follows:

This would see the relative tax on your real income of £25,000 rise from 11.5% to a staggering 114.6% – meaning you would actually pay more tax than you make in profit.

As the new regime is phased in, the landlord in this example could see their tax rise almost tenfold (note that current tax bands are used for each year)

What should landlords do?

If you think that you may be affected by the new tax rules, be sure to seek advice from a qualified accountant or tax advisor.

It is also important to cut down on your running costs where you can. To see if you might be able to reduce your buy to let mortgage interest bill, contact your mortgage broker for recommendations on suitable products from the buy to let marketplace.